Following the conclusion of the Federal Reserve's aggressive interest rate increases in 2023, the fixed income market has regained prominence as a crucial component of investment portfolios. Even short-duration, risk-free three-month Treasury bills are currently yielding over 3.5%, making them an attractive option for investors. This renewed interest necessitates a strategic approach to fixed income allocation, particularly when considering broad market exposure versus more conservative treasury investments.
Investors looking to diversify their portfolios with fixed income have two primary avenues to consider: short-term Treasuries, which offer a defensive, lower-risk approach with reasonable yields, ideal for anticipating potential market downturns, and the total bond market, representing a more traditional allocation suitable for long-term growth within a diversified portfolio. Within Vanguard's offerings, these strategies are embodied by the Vanguard Short-Term Treasury ETF (VGSH) and the Vanguard Total Bond Market ETF (BND), respectively. While both present compelling arguments, a nuanced understanding of their structures and market behavior is essential for making an informed decision.
The Vanguard Short-Term Treasury ETF focuses predominantly on high-quality U.S. Treasury bonds with an average maturity ranging from one to three years, currently offering a yield of 3.6%. This ETF is primarily designed as a low-risk income vehicle, providing a hedge against sharp equity market corrections. Historically, Treasuries have often demonstrated an inverse correlation with stocks, meaning their value tends to appreciate when stock prices decline, thus serving as a protective mechanism in volatile markets. However, this protective quality can diminish in inflationary environments combined with rising interest rates, as observed in 2022 when both stock and bond prices fell simultaneously.
Conversely, the Vanguard Total Bond Market ETF offers extensive exposure to the investment-grade bond market, encompassing Treasuries, corporate bonds, and mortgage-backed securities (MBS), with a current yield of 4.2%. This broader diversification makes BND a suitable choice for a core portfolio allocation rather than a pure risk-off instrument. While the significant Treasury component of BND shares characteristics with VGSH, its inclusion of corporate bonds introduces elements of credit risk and increased sensitivity to interest rate fluctuations. Corporate bonds, despite being fixed income, may experience declines during stock market downturns due to their inherent credit risk, differentiating BND's performance from a pure Treasury ETF in certain market conditions.
Considering the prevailing economic landscape and anticipated future trends, the Vanguard Total Bond Market ETF appears to be the more advantageous option for many investors. While a pure Treasury ETF like VGSH might be preferable for those anticipating a significant market correction, current high-level economic indicators suggest a resilient, possibly expanding, economy. In such an environment, the inclusion of corporate bonds within BND not only enhances its upside potential but also offers a higher yield, aligning better with conditions where economic growth is expected to continue. This comprehensive approach to fixed income investing allows for both stability and growth potential.